ASWATH DAMODARAN: These are the 2 biggest mistakes people make when investing overseas

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Aswath Damodaran believes investors make two common valuation errors when it comes to country risk exposure: They focus on countries instead of companies and obsess over past mistakes.

The goal of country selection in portfolio management is to minimize risk by maximizing exposure to different countries. In an increasingly globalized world, country risk exposure does not need to come from companies in different countries. According to Damodaran, US and European investors do not even need to look beyond their domestic markets.

"I could, using just the S&P 500 companies, get exposed to pretty much every market in the world," he told Shreenivas Kunte, CFA, during a recent Take 15 interview.

Damodaran believes that looking for specific countries to invest in is dangerous, cautioning that "cheap countries are cheap for a reason." For example, it would be irresponsible to invest more in Russia than its position in the global economy merits, even though it is probably the cheapest market in the world. On the other hand, Brazil looks like a cheap market right now, but investors should find exposure to Brazil at the right price, rather than avoid it outright.

Aswath Damodaran, Professor of Finance at NYU Stern
Matthew Borin

Damodaran also advises investors to distinguish between different types of risk.

Continuous risk — the notion that volatility is more extreme in developing markets than in developed ones — is a simple problem for investors since they can factor it into risk premiums. Truncation or discreet risk is the possibility of events like wars or coups. Damodaran warns that this risk is difficult to analyze with the existing tools and cannot be captured by discount rates, so investors should not lump these two types of risk together.

Another issue with valuation across countries is that different accounting practices can confuse pricing multiples.

"The more you work down an income statement, the more danger there is to these multiples because what you might be capturing is not a cheap market but differences in accounting across countries," Damodaran said.

He thinks this problem can be circumvented by using simple, aggregated multiples that do not require many intermediate steps. Revenue multiples are more robust in recognizing accounting discrepancies than EBITDA multiples, which in turn are better than net income multiples.

Damodaran doesn't believe that any formulaic approach to revaluing risk and redesigning valuation models could address volatility. He believes that the balancing act of learning from mistakes without overreacting is more psychological than anything.

"The more you obsess about your mistakes and try to avoid past mistakes, the more you make new mistakes," Damodaran said.

While it is important to be dynamic, keep feedback loops open, and admit to being wrong, it is also vital to accept a degree of uncertainty. For example, he recommends that people who lost money investing in China at the start of the year not blame the valuation models they used, as no model could have predicted the slowdown.

"If you react too much and adjust your valuation models, it's like generals who fight the last war. They recreate armies saying, 'If I had done that, I'd have won the last war,'" Damodaran said. "Too many analysts redesign valuation models to avoid mistakes from the past. The reality of valuation is the next mistake is going to look nothing like the past one."

To Damodaran, country selection is not an investment strategy but part of building a portfolio that minimizes risk.

"I'm still to find a person who's consistently made money as a macro asset allocator. I think there are people who get lucky and they might move into the right market at the right time," he said. "If I try to chase success in country risk, I end up doing stupid things in my portfolio."